Aftershocks, Part 1: That Austrian Bank

March 8, 2015

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Sometimes little things are the start of much bigger things. Probably the most famous historical example of this is the June 1914 assassination of an Austrian archduke who, it’s safe to say, 99% of the world had neither heard of nor cared about. But the aftershocks of the deed produced the biggest war in human history.

More recently, the US government’s 2008 decision to allow mid-tier investment bank Lehman Brothers to fail is frequently blamed for turning a mortgage bubble into a global financial collapse.

So in trying to understand the world it pays to look beyond the headlines to the secondary and tertiary effects of whatever is happening. And right now, more than the usual number of events and/or trends seem capable of turning a sector-specific story into a broader crisis. This series of columns will look at some of them, beginning, appropriately, with Austria, where the government has decided to “bail-in” rather than a bail out a failed bank. Already, the collateral damage is mounting:

Heta Damage Spreads in Austrian Downgrades, German Losses
(Bloomberg) — Austria’s decision to wind down Heta Asset Resolution AG sent ripples through the financial system, causing credit rating downgrades in Austria and bank losses in Germany.

Moody’s Investors Service cut the rating of Carinthia province, which guarantees 10.2 billion euros ($11.1 billion) of Heta’s debt, by four levels to Baa3 from A2, and said it may lower the ratings of three state-owned Austrian banks exposed to it. Dexia SA’s German unit, Deutsche Pfandbriefbank AG and NRW Bank said yesterday they own Heta bonds that may suffer losses.

“Notwithstanding the intention of the central government to protect taxpayers under the new banking resolution regime, Moody’s sees the steps taken so far as adding higher uncertainty to developments,” the ratings company said late Friday in a statement on the Carinthia downgrade. “Susceptibility to an adverse scenario has increased as a result.”

Austria paved the way for imposing losses on Heta’s bondholders when it ruled out further support for the “bad bank” of Hypo Alpe-Adria-Bank International AG March 1. Using powers set out in European Union and Austrian bank laws covering debt reorganization, the Finanzmarktaufsicht regulator ordered a 15-month debt moratorium while it plans resolution of Heta’s 18 billion euros of assets.

Carinthia’s guarantees, which peaked at 25 billion euros in 2006, were the main justification for Hypo Alpe’s public rescue in 2009 and the biggest conundrum in its wind-down.

Can’t Pay
With budgeted revenue of 2.36 billion euros this year, the southern province of 556,000 people would be unable to honor the guarantees if they came due now or in a year’s time, Governor Peter Kaiser told Austrian radio ORF on Tuesday.

The guarantees “could exceed Carinthia’s liquidity resources, lead to increased financial leverage and could require some form of extraordinary central government support,” Moody’s said.

Finance Minister Hans Joerg Schelling has said repeatedly that the Austrian government isn’t liable to cover Carinthia’s guarantees.

German banks yesterday also emerged as major Heta bondholders. Dexia’s Dexia Kommunalbank Deutschland AG said it owns 395 million euros of Heta bonds and will take an unspecified charge in the first quarter. Deutsche Pfandbriefbank AG also owns 395 million euros of Heta bonds and said it will write them down by 120 million euros, cutting its expected pretax profit by two-thirds.

Some thoughts
It’s amazing how fast credit ratings revert to their intrinsic value when artificial government support is removed. And the above list of potential victims doesn’t include the counterparties on whatever credit default swaps are out there on Heta-related bonds. So more scary headlines are coming.

It’s also important to note just how tiny these numbers are. Not a single amount mentioned in the above article is over 25 billion euros. That’s chump change in today’s mega-bank world. Yet in the absence of a government backstop it’s enough to cause cascading credit downgrades and maybe even the bankruptcy of an entire Austrian state.

So Austria and by implication the rest of the eurozone now face a tricky choice: Stick with the bail-in program and risk a highly-unpredictable cross-border contagion. Or go back to the tried-and-true bail out, with the higher deficits and rising debt — and angry voters — that that implies.

Over the past couple of decades, governments have generally blinked when confronted with the prospect of actually letting markets clear bad debts and other misallocated capital. Starting in the mid-1990s with the what came to be known as the “Greenspan put” governments around the world have made it clear to the financial sector that no mistake is too egregious to be unworthy of a central bank backstop. So leverage up, roll the dice, collect those bonuses, and don’t worry about the consequences. The result is a bunch of banks, pension funds and hedge funds whose balance sheets are stuffed with paper that has value only if 1) accounting rules continue to support “mark to fantasy” bookkeeping and 2) governments (via taxpayers) stand ready to convert that bad paper to newly-created currency upon demand.

As taxpayers and voters have caught onto the scam, they’ve raised the political costs for governments, forcing Austria’s leaders have to decide which group — unstable financial markets or an appalled electorate — is more dangerous to cross heading into the next election. Either choice brings its own series of aftershocks and systemic risks.